Deficiency Tax: What It Is and Real-Life Examples


Deficiency tax refers to the discrepancy between the reported tax amount on a tax return and the IRS-determined owed amount. Learn about its causes, consequences, and how to address deficiencies effectively.

Understanding deficiency tax

Deficiency tax is a term that comes into play when taxpayers report an income amount to the Internal Revenue Service (IRS) that differs from the amount the IRS calculates as owed. It’s important to note that the term “deficiency” pertains only to shortfalls, not surpluses, and often leads to deficiency letters sent to taxpayers. In this comprehensive guide, we will delve deeper into deficiency tax, its implications, and how to address it.

How does a deficiency arise?

A deficiency typically arises during internal IRS audits that involve cross-referencing various submitted forms. Entities such as banks, employers, and other businesses report taxpayer liabilities to the IRS. When the amount reported by the taxpayer is less than what third-party entities report, a deficiency is triggered. This usually happens when taxpayers fail to report certain sources of income.

For example, a deficiency may result when a W-2 submitted by an employer is not reported as income by the taxpayer. The IRS closely scrutinizes the documentation provided by employers and matches it with the information reported by the taxpayer. If the IRS finds a W-2 from an employer that the taxpayer didn’t report, a deficiency is assessed. Deficiencies can also occur due to inconsistencies in reported data, such as disparities between the W-2 and income reported on tax documents like the 1040 form. Whether these discrepancies are intentional or accidental, any additional tax liability is treated as a deficiency.

In some cases, an official audit can lead to a deficiency. During an audit, the IRS examines all the information and documentation related to a particular tax year’s return. If the IRS determines that additional taxes are owed, it results in a deficiency notice. To avoid being served with a deficiency notice, follow these IRS-recommended steps:

  • Keep accurate and complete records of your income and expenses.
  • Wait until you have all your income statements, such as W-2s and 1099s, before filing your tax return.
  • Verify the accuracy of records received from your employer, mortgage company, bank, or other sources of income.
  • Include all your income on your tax return.
  • Follow the instructions on how to report income, expenses, and deductions accurately.
  • If you receive additional information after filing your return, file an amended tax return.

Addressing notices of deficiency

When a taxpayer receives a Notice of Deficiency (Form CP3219A) after ignoring a first notice and Examination Report, it’s crucial to understand that this notice is not a tax bill. Instead, it specifies the inconsistencies between the taxpayer’s reported tax liability and the IRS-assessed liability. If the taxpayer agrees with the deficiency indicated by the IRS, they must respond within 90 days using Form 5564, Notice of Deficiency – Waiver. However, if the taxpayer disagrees with the assessment, they have the option to contest the deficiency by filing a petition with the U.S. Tax Court. It’s essential to file the petition by the deadline indicated on the notice since the court cannot consider cases filed late, and there are no extensions.

Ignoring a Notice of Deficiency and failing to pay the tax liability can lead to several consequences. The IRS may enforce tax liens on your wages or bank accounts, seize your property or assets through tax levies, or initiate a criminal investigation, potentially resulting in legal consequences, including jail time.

Deficiency due to fraud or identity theft

Deficiency tax may also arise due to fraud or identity theft. In cases where an incorrect income amount is intentionally listed on the taxpayer’s W-2 by the employer, it can result in fraud. Identity theft, on the other hand, may occur when an individual falsely claims another person’s name and social security number while working. In such cases, the taxpayer should report the issue to the IRS by submitting Form 14039, Identity Theft Affidavit.

It’s important to note that taxpayers should not be held liable for income tax on earnings they did not personally earn. Addressing deficiency tax due to fraud or identity theft requires prompt action and cooperation with the IRS to rectify the situation.

Common causes of deficiency tax

Understanding the various scenarios that can lead to deficiency tax is essential for taxpayers. Here, we’ll explore some common causes of deficiency tax that taxpayers may encounter:

Underreported income

One of the primary reasons for deficiency tax is underreported income. This occurs when a taxpayer fails to report all sources of income on their tax return. For example, freelance income, rental income, or cash earnings must be accurately reported. Failure to do so can lead to a deficiency when the IRS discovers the unreported income during an audit.

Inconsistencies in reported data

In some cases, discrepancies arise due to inconsistencies in reported data. This could include situations where the information on a W-2 form provided by an employer doesn’t match the details reported on the taxpayer’s tax documents, such as the 1040 form. Whether these disparities are intentional or accidental, they can result in additional tax liability, leading to a deficiency.

Official audits

Official IRS audits, while not always resulting in deficiencies, can trigger them. During an audit, the IRS reviews all the documentation related to a specific tax year’s return. If the audit reveals that additional taxes are owed, a deficiency notice is issued to the taxpayer.

Deficiency tax and legal consequences

It’s important for taxpayers to be aware of the potential legal consequences of ignoring a deficiency notice. Failure to address a deficiency can have severe repercussions, including:

Tax liens on wages and bank accounts

If a taxpayer ignores a deficiency notice and doesn’t pay the tax liability, the IRS can enforce tax liens. Tax liens allow the IRS to claim a portion of the taxpayer’s wages and can also be imposed on their bank accounts. This can significantly impact a taxpayer’s financial stability.

Asset seizures through tax levies

Ignoring a deficiency can lead to tax levies, where the IRS seizes a taxpayer’s property or other assets to cover the outstanding tax debt. This can include real estate, vehicles, or other valuable assets. Tax levies can be financially devastating and disruptive to a taxpayer’s life.

Potential criminal investigations

In some cases, ignoring deficiency notices can escalate to criminal investigations. If the IRS suspects deliberate tax evasion or fraudulent activities, they may launch a criminal investigation. This investigation could lead to legal consequences, including fines and even imprisonment for the taxpayer.

Reporting deficiency tax due to fraud or identity theft

Deficiency tax resulting from fraud or identity theft requires a specific course of action. Here, we’ll explore the steps to take if you suspect that you are a victim of fraud or identity theft related to your tax return:

Reporting fraudulent W-2 information

If you believe that your employer has intentionally provided incorrect information on your W-2, leading to a deficiency, it’s crucial to report this issue to the IRS. Submit any evidence you have to support your claims and work with the IRS to rectify the situation.

Identity theft and its impact on deficiency tax

Identity theft can result in a deficiency when an individual uses your name and social security number to earn income falsely. If you suspect that you are a victim of identity theft, you should report this to the IRS immediately. Submit Form 14039, the Identity Theft Affidavit, to inform the IRS of the situation and take the necessary steps to clear your name from any tax liability you didn’t incur.


Deficiency tax is a critical aspect of taxation that can have significant implications for taxpayers. Understanding the causes, consequences, and the necessary steps to address deficiencies is essential for maintaining compliance with the IRS and preventing potential legal issues. To avoid deficiency notices, it’s vital to keep accurate records, report all sources of income, and follow IRS guidelines for reporting. If you receive a Notice of Deficiency, take it seriously and respond promptly to either resolve the deficiency or contest it through legal channels. By staying informed and proactive, taxpayers can navigate deficiency tax issues effectively.

Frequently asked questions

What should I do if I receive a notice of deficiency?

If you receive a Notice of Deficiency (Form CP3219A) from the IRS, it’s essential to take it seriously. This notice is not a tax bill but rather a proposal outlining inconsistencies between your reported tax liability and the IRS-assessed liability. If you agree with the deficiency, you must respond within 90 days using Form 5564, Notice of Deficiency – Waiver. If you disagree, you can contest the deficiency by filing a petition with the U.S. Tax Court. Ensure that you adhere to the specified deadline for the petition, as there are no extensions.

What if I can’t afford to pay the deficiency amount?

If you find yourself unable to pay the deficiency amount immediately, you can explore various options offered by the IRS. One option is setting up a payment plan or installment agreement to pay the tax debt over time. Additionally, the IRS may consider your financial situation and offer alternatives like an Offer in Compromise or temporarily delaying collection actions. It’s crucial to contact the IRS to discuss your situation and determine the best course of action.

Can a deficiency notice result from mathematical errors on my tax return?

Yes, mathematical errors or other discrepancies on your tax return can lead to a deficiency notice. While these errors are not related to unreported income, they can result in discrepancies between your reported tax liability and the IRS assessment. If you receive a deficiency notice due to such errors, you can typically resolve it by reviewing your tax return, identifying the mistakes, and correcting them. The IRS will then reevaluate your tax liability accordingly.

What are the consequences of ignoring a notice of deficiency?

Ignoring a Notice of Deficiency can lead to severe consequences. The IRS can enforce tax liens on your wages and bank accounts, seize your property or assets through tax levies, or even initiate criminal investigations that may result in legal penalties, including fines and imprisonment. It’s highly recommended not to disregard deficiency notices and to take prompt action to address them.

Is it possible to avoid receiving a deficiency notice?

While there’s no foolproof way to guarantee you won’t receive a deficiency notice, following best practices can reduce the likelihood of encountering such issues. This includes keeping accurate and complete records, reporting all sources of income, and adhering to IRS guidelines for income reporting. By double-checking your tax return and ensuring it aligns with the information provided by employers and other entities, you can minimize the risk of receiving a deficiency notice.

Key takeaways

  • Deficiency tax arises when the reported income on a tax return differs from the IRS-determined amount.
  • Common causes of deficiency tax include unreported income, inconsistencies in reported data, and official audits.
  • Respond promptly to a Notice of Deficiency, either by agreeing to the IRS assessment or contesting it through the U.S. Tax Court.
  • Ignoring deficiency notices can lead to severe consequences, including tax liens, asset seizures, and criminal investigations.
  • Deficiency tax due to fraud or identity theft should be reported to the IRS using the appropriate forms.
View article sources
  1. Glossary of Tax Terms – OECD
  2. Tax Expenditure Reform: An Essential Ingredient of … – Center on Budget and Policy Priorities
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  4. Tax structure and tax evasion final – CEPAL